The Dull 2018 Consensus

The Dull 2018 Consensus

12 Feb 2018 - Martin Shenfield

Equity markets are arguably getting a little frothy short term & some sort of consolidation would be healthy, but we re-iterate that we are not yet in a full scale bubble; although ultimately before the music stops we expect to have fully experienced one!

Apart from all the obvious longstanding rationales for the equity bull run we would emphasize that the consensus is still too cautious re the sustainability of this global economic cycle. My colleague Dario Perkins highlights again below why there is no ‘macro ‘ reason for this cycle to end by 2018 (which seems to be the consensus?).

Indeed if he & Charles Dumas are correct about the under-reporting of productivity improvements & the likely acceleration in the latter we may be in for an extended period of economic growth. The main risks to markets are therefore ‘market’ not macro, even if central banks are unnecessarily stoking an asset bubble with their obsession with chasing an arbitrary 2% inflation rate when the US & EA are already growing significantly above trend. A sharp spike in yields concomitant with a USD surge(very unlikely in the short term) is the most likely end game-so watch the cross currency basis for any sharp widening suggesting a material squeeze in offshore USD funding which would hit EMs, Japanese banks, etc hard & more generally equities.

The sellside spent December flooding the investment community with long, sometimes tedious analysis about what the global economy and financial markets would do in 2018. Some of these reports – not pointing fingers – are already out of date. Because we are kind and thoughtful at TS Lombard, we have developed a tradition of reading these reports and summarising the ‘consensus’ for our clients – so they don’t have do. While this exercise is rarely something to get excited about, even for an economist, this time it is has been particularly dull. Most of these studies assume 2018 will be exactly like 2017 (was supposed to be), with slightly more inflation and a little bit of extra policy tightening. This is pretty much exactly what the consensus said 12 months ago, or 12 months before that. Worse, several of these studies even adopt the same title: ‘Rational exuberance’. Since this is also the message most central banks are pushing, it suggests the whole macroeconomic community is lacking imagination.

It is easy to see how the consensus got into this situation – 2017 was also fairly dull. While investors spent most of the year worrying about the end of the cycle, global growth actually strengthened and risk assets rallied. It became a cliché, but people even started to call this the ‘most hated bull market in history’. And with inflation unexpectedly dipping during the first six months of the year, it was clear that Goldilocks was making an unscheduled return. Since some of this was difficult to explain – particularly the dip in inflation (we blamed structural forces) – perhaps it makes sense for economists to extrapolate recent trends into the future. You could even argue we did something similar in our own Year Ahead document, which in term of simple growth and inflation projections wasn’t too far off the consensus. But where I think we gain extra points, is in trying to explain why this cycle is unusual and whether the interplay between markets and macroeconomic could cause problems over the next few years.

Our most important theme for 2018 is that there is no ‘macro’ reason for this cycle to end. The things that usually prompt recessions – inflation, the perceived threat of inflation, a profits squeeze, monetary tightening and/or overinvestment – are largely absent. In fact, we see several structural forces that could mean this cycle lasts much longer than everyone is expecting, particularly if Germany ‘rebalances’ while new technologies deliver a powerful revival in productivity (assuming the authorities work out how to measure it). As far as I’m aware, no other sellside year ahead report expects anything other than a temporary burst of growth in 2018. We think the main risks for 2018 are ‘market’ not macro. This is where it is important to question what the major central banks are doing. Right now we seem to be in a bizarre situation where the Federal Reserve is reluctant to take on bond markets, convinced that the flat yield curve is telling it something profound about ‘equilibrium interest rates’, while the ECB and BoJ are simultaneously manipulating those same yields through their massive QE programmes (creating an acute shortage of safe assets). This is the perfect environment for bubbles. But since these policies look sure to continue through 2018, any ‘bubbles’ will probably bubblier.

In 2019, the outlook gets trickier. Some sellside reports acknowledge this, but don’t devote a great deal of time to it. The consensus can’t seem to decide whether the main problem will be a late-cycle burst of inflation (forcing long-term interest rates higher) or an inverted yield curve. We think a sharp spike in yields is the main danger, particular when central banks have ended their QE programmes and the shortage of global safe assets begins to unwind. This is also likely to be the trigger for a wider selloff in risk assets and a significant injection of volatility in global markets. What started out as a 2004-06 style ‘conundrum’ could turn into a 1994-style blowout. The good news is that this needn’t herald a turning point in the broader macro cycle, let alone a repeat of what happened in 2008. To the extent there are bubbles, they are unleveraged and most major economies (including the US) are not as sensitive to long-term interest rates as often feared. But, of course, it depends how large these bubbles have become by 2019.

A large correction in risk assets would not only be more damaging to the global economy, but it could also undermine the orthodoxy of modern central banks – who will surely be blamed, rightly or wrongly, for their continued obsession will narrow definitions of price stability.